Those who are looking for ways to generate investment income through dividends often allocate a portion of their portfolios to utility stocks. Utilities have long been viewed as a conservative option that enables investors to capture higher dividends than are available in most areas of the stock market.
The Benefits of Utility Stocks
Utilities are companies that deliver essential services such as water, gas, and electricity. Since these services are always in demand no matter how fast or slowly the economy is growing, the sector tends to be one of the more stable areas of the stock market in terms of its day-to-day performance. Utility stocks also tend to hold up better in falling markets, since investors are usually in less of a rush to sell their lower-risk investments when the broader environment turns sour. While utility stocks are more risky than most asset classes within the bond market, they are generally seen as being lower risk compare to the overall stock market.
The primary benefit of utilities is that they typically pay above-market dividends. In the past decade, the exchange-traded fund Select Sector SPDR-Utilities (ticker: XLU) – which invests across the entire U.S. utilities sector with an emphasis on the largest companies – has typically offered a yield about 1.75 to 2.5 times that of the S&P 500 Index (a measure of broader U.S. market performance). Notably, it has done so with a lower level of volatility than the market as a whole.
High Dividends, But Limited Room for Capital Appreciation
The flip side is that the potential for longer-term capital appreciation is limited with utilities. The growth opportunities for most companies in the sector is limited, and this is reflected in their stock price performance. One benefit of this, of course, is that with fewer opportunities to invest for future growth, the companies have more cash on hand to pay out dividends.
Over time, however, above-average dividends can have a significant impact on total return. Consider that the utilities ETF mentioned above. From its debut on December 22, 1998 through March 12, 2013, XLU produced a cumulative total return of 101.49% and an average annual total return of 5.05%. In that same period, the SPDR S&P 500 ETF (SPY), which tracks the S&P 500 Index - a broad measure of performance for U.S. stocks - had a cumulative total return of 70.44% and an average annual total return of 3.80%. This isn't meant to illustrate that utilities are a superior investment, but rather to show that an extra few percentage points of dividend yield has the potential to add up over the long term.
The Risks of Utility Stocks
Like any segment of the stock market, utilities are subject to broader market forces. During both of the major market declines of the past decade – 2001-2002 and 2008-2009 – utilities stocks lost about half of their value on a price basis (i.e., not counting dividends). Income investors need to keep this in mind when deciding between an investment in bonds or dividend-paying stocks such as utilities.
Two other factors can have a negative impact on the performance of utilities stocks. First, rising interest rates can cause the sector to underperform for two reasons: 1) higher rates increase utilities’ interest burden because companies in the sector tend to be capital-intensive and therefore more heavily indebted and 2) higher rates cause income-oriented investors to gravitate toward bonds and away from riskier yield options in the stock market. In addition, the sector is heavily regulated and therefore vulnerable to shifts in government policy.
How to Invest in Utility Stocks
You can invest in utility stocks through any broker. It’s possible to invest in either individual utility stocks, mutual funds that specialize in the sector, or ETFs such as Select Sector SPDR-Utilities. Be sure to contact a financial advisor or use all the vast online resources available to conduct comprehensive research before investing.
Disclaimer: The information on this site is provided for discussion purposes only, and should not be construed as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities.